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LLCs, LLPs, and the Passive Loss Rules

By Cecilia Calderilla, CPA, Irvine, CA

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Tax Section

Editor: Mark G. Cook, CPA, MBA

Since
the early 1990s, limited liability company (LLC) and limited
liability partnership (LLP) entities have been popular vehicles
in which to structure a business. Their popularity is due to the
fact that they can be used to limit personal liability and to
avoid double taxation.

Sec. 469(h)(2) treats a limited
partner’s losses from an interest in a limited partnership as
presumptively passive. The IRS has taken the position that a
taxpayer who is a member of an LLC or LLP that is taxed as a
partnership should be treated as a limited partner and therefore
any losses passed through to the member are passive activity
losses. This is to the taxpayer’s disadvantage because it delays
the deduction of losses and increases the amount of taxes
currently paid by business owners.

In Thompson,
No. 06-211 T (Fed. Cl. 7/20/09), the Court of Federal Claims
held that an ownership interest in an LLC should not be treated
as presumptively passive under Sec. 469 for two main reasons.
First, the court found that Temp. Regs. Sec. 1.469-5T(e) applied
only to an entity organized as a limited partnership under state
law. Second, the court held that the rationale for treating
limited partnership interests as presumptively passive did not
apply to LLC interests because an LLC member, unlike a limited
partner, is not statutorily prohibited from participating in the
entity’s affairs. Therefore, it is possible that an LLC member
could materially participate in an LLC’s business, making the
passive activity presumption improper.

Background of
the Case

In the Thompson case, the taxpayer
owned an airline charter that operated as an LLC under Texas
state law. The business, Mountain Air Charter, LLC, was owned
99% by the taxpayer directly; the remaining 1% was owned by JRT
Holdings, Inc., an S corporation, which was also owned by the
taxpayer. During 2002 and 2003, the company incurred substantial
losses, which the taxpayer used to offset ordinary income on his
personal tax return. On audit, the IRS took the position that
the LLC was a limited partnership for purposes of Sec.
469(h)(2), which was accordingly subject to the passive activity
rules of Sec. 469. Therefore, the losses had incorrectly been
deducted.

The IRS’s Position

The IRS based its
position on Temp. Regs. Sec. 1.469-5T(e)(3)(i):

(3) Limited partnership interest (i) In
general.—Except as provided in paragraph (e)(3)(ii) of this
section, for purposes of section 469(h)(2) and this paragraph
(e), a partnership interest shall be treated as a limited
partnership interest if—(A) Such interest is designated a
“limited partnership interest” in the limited partnership
agreement or the certificate of limited partnership, without
regard to whether the liability of the holder of such interest
for obligations of the partnership is limited under the
applicable State law; or (B) The liability of the holder of such
interest for obligations of the partnership is limited, under
the law of the State in which the partnership is organized, to a
determinable fixed amount (for example, the sum of the holder’s
capital contributions to the partnership and contractual
obligations to make additional capital contributions to the
partnership).

According to the IRS, because the
LLC had limited liability, the LLC interest was a “partnership
interest [that] shall be treated as a limited partnership
interest” for purposes of Sec. 469(h)(2), and therefore the
interest should be treated as an interest in a passive activity.

The Court’s Holding

The Court of Federal Claims
found that Sec. 469(h)(2) and the regulations made it clear that
a limited partnership interest must be an interest in an entity
established under state law as a limited partnership and not
merely an entity that elects to be taxed as a partnership. As
set forth in Temp. Regs. Sec. 1.469-5T(e)(3)(i)(A), “Such
interest [must be] designated a ‘limited partnership interest’
in the limited partnership agreement or the certificate of
limited partnership” in order to be considered a limited
partnership. Because Mountain Air Charter was a valid Texas LLC,
not a limited partnership, the court held that an interest in
Mountain Air should not be treated as a limited partnership
interest for purposes of Sec. 469.

The court also
addressed the application of the general partnership exception
in Temp. Regs. Sec. 1.469-5T(e)(3)(ii), which states:

(ii) Limited partner holding general partner
interest.—A partnership interest of an individual shall not be
treated as a limited partnership interest for the individual’s
taxable year if the individual is a general partner in the
partnership at all times during the partnership’s taxable year
ending with or within the individual’s taxable year (or portion
of the partnership’s taxable year during which the individual
(directly or indirectly) owns such limited partnership
interest).

The court found that whether the
exception applied depended on the potential for participation in
the entity. According to the court, the rationale for treating a
limited partnership interest as presumptively passive did not
extend to LLC interests because there were no statutory
limitations on the partners’ or members’ participation in an LLC
under state law, and it therefore could not be presumed that an
LLC member did not materially participate.

This led the
court to conclude that it was inappropriate to presume that the
interests in an LLC were passive. Therefore, the court held that
Thompson’s interest should be treated as a general partnership
interest that was covered by the exception in Temp. Regs. Sec.
1.469-5T(e)(3)(ii). In Thompson’s case, because the parties had
stipulated that Thompson would meet the material participation
requirements of Sec. 469 with respect to Mountain Air Charter if
Temp. Regs. Sec. 1.469-5T(e) (3) did not apply, the court held
that Thompson’s losses from the LLC were not limited.

In
making its holding on the general partnership exception, the
court cited with approval the Tax Court’s decision in
Garnett, 132 T.C. No. 19 (2009), which was issued
shortly before the decision in the Thompson case. In
Garnett, the Tax Court addressed the same issue as in
Thompson with respect to both LLC and LLP interests.
While the Tax Court agreed with the Court of Federal Claims on
the application of the general partnership exception, it did not
agree that an LLC interest should not be treated as a limited
partnership interest because an LLC is not a limited partnership
under state law. The Tax Court concluded that Congress had
contemplated that entities that are substantially equivalent to
limited partnerships are considered presumptively passive under
Sec. 469(h)(2), so an LLC interest was not excepted from Sec.
469(h)(2) simply because it was not a limited partnership under
state law.

Conclusion

These holdings favor LLC
members’ ability to take losses currently. In 2009,
practitioners probably have many clients with LLCs that have
incurred substantial losses either in the current year or in
prior years. One way to assist these clients is to reevaluate
the position taken on prioryear tax returns to see if losses
have been suspended. If losses are substantial, it may be worth
the time and cost to amend those returns. However, since there
is a higher risk of audit when returns are amended, a
practitioner’s best practice would be to sit down with the
client and document, in either a written memo or a flow chart,
the flowthrough of income and losses and the client’s
participation in those companies.

EditorNotes

Mark Cook is a partner at Singer Lewak LLP
in Irvine, CA.

Unless otherwise noted, contributors are members of or
associated with Singer Lewak LLP.The editor would like to
offer a special thanks to Jennifer Allison, J.D., for her
assistance with this column.

For additional
information about these items, contact Mr. Cook at (949)
261-8600, ext. 2143, or mcook@singerlewak.com.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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